07 Dec Can China Protect Its AssetBacked Securities Market From Another Credit Crisis?

“The Credit Crisis of 2008 would not have happened if senior credit managers had followed the 5 Cs of Credit,” said a chorus of senior credit rating executives in a recent closeddoor event I led in New York.

What Are ‘the 5Cs’ anyway?

It’s an oldfashioned model of credit behavior based on five factors beginning with the letter “C” and dating back to an era when every loan was a special case. If you can list all five, you’re probably over 65.

According to the 5Cs, a loan is ‘moneygood’ if it has (1) a conscientious borrower (character) with (2) adequate resources to pay claims (capacity) from (3) predictable future cash flows (capital), which may be augmented by (4) pledging assets (collateral) and further augmented (5) with covenants designed to withstand adversity (conditions).

Financial engineering has changed how we look at credit. We standardize the risk into ranges of default probability (“credit grades”). We don’t always hold it to maturity. Often we bundle and trade it.

But engineering hasn’t altered the 5Cs. They are a nearperfect, universally valid lexicon of credit risk for use in credit forecasting.

Are the 5Cs Relevant to China?

Yes. Consider Hong Kong RMBS in the 1990s. These securities were backed by loan pools using different underwriting strategies. In one strategy, the bank focused on the resale value of the residential real estate collateral. They read the fine print on their legal standing, monitored the daily bids and offers on flats attached to their loans (capital, collateral and conditions), and tended to gloss over borrower payment and indebtedness data (character, capacity). When the Asian Crisis hit, they struggled.

Banks from the other strategy focused on borrower creditworthiness (character, capacity) rather than real estate and paid special attention to thirdparty and family support in evaluating the loan package. That’s something we don’t do much in the U.S., but in the Chinese view character doesn’t end with self. It is constructed from one’s network of relationships. Many credit professionals told me, as Moody’s analyst rating Hong Kong RMBS, they viewed relationship networks as a creditpositive: a source of contingent liquidity if the borrower came under financial strain.

China’s Weak Points: Collateral, Capacity and Capital

During the Asian Crisis, I saw how this kind of “network capital” could backfire, when friends and relations came under financial strain and pressured the RMBS borrowers for money. Call it “network correlation risk.” The same pressures were at play in China’s severe triangular debt problem in its stateowned enterprise (SOE) sector in the 1990s. Triangular debt occurs when Firm A delivers goods or services to Firm B on account. B can’t pay A until its receivables from Firm C turn. But C has to get paid from, among other clients, A.

In the language of the 5Cs, intercompany indebtedness signifies a weakening of collateral, capacity and capital. Chronic liquidity shortages may become a credit problem. If the collateral does not convert to cash as it comes due, the arm’slength value is weakened. Slowpaying collateral curtails cash flow and impairs the firm’s capacity to pay its vendors and employees. The firm turns to thirdparty liquidity to meet current expenses. As leverage rises, debt capacity is constrained. Capital quality is reduced. Credit is compromised. Financial flexibility is curtailed.

Triangular Debt And China’s ABS Market

China’s triangular debt problem originated in its structural transition to capitalism, but the Asian Crisis made things worse. Back then, a few Chinese institutions responded to liquidity pressures by experimenting with securitization, but China’s main reform strategy was the creation of asset management companies (AMCs) to purchase nonperforming loans from stateowned banks, thereby injecting RMB 1.4 trillion of cash to give China’s economy a fresh start.

Roll the clock forward to midyear 2012. China’s State Council ordered a probe into intercompany debt levels and a rash of articles on China’s new triangular debt problem surfaced. Wind Information reported that in the first half of 2012, while listed company turnover on the Ashare market climbed 8% yearonyear, receivables ballooned by 37%, to RMB 2.2 trillion (USD 345.15 billion). China’s debt levels were now in excess of 200% of GDP, 25% higher than in 2009. And, China’s ABS market was officially restarted on May 17, 2012.

At the time, China’s rationale for promoting ABS was to improve credit market capital efficiency and transparency. But we must never forget that in the U.S., when the Dot Com Bubble burst, securitization exploded with new trading strategies backed by flawed rating models and fake data, in blatant violation of credit’s first “C,” character. That’s what senior executives in my closed door session meant about the 5Cs.

ABS is supposed to free up the capital of the firm by tapping into the liquidity and credit of high quality receivables. But so far, China’s ABS market doesn’t really work that way. The bankoriented CASS market doesn’t free up company capital, and the SOEoriented ABSP market runs to a great extent on guarantees. Not only is there significant “network correlation risk” in this market, but now it also appears that some maturing securities present extension risk.

The question for China is whether, either through cultural character or better adaptability to conditions, it can protect its ABS market from a U.S.style collapse?